Options Backdating

Options backdating is the practice of granting an employee stock option that is dated prior to the date that the company actually granted the option. This practice raises a number of legal and accounting issues; it may or may not be unlawful depending on the circumstances.

In 1992 the SEC imposed a rule requiring companies to report executive stock options in detail. Even after the rule, some executives got away with it for years because they could legally delay reporting option grants for so long that it was virtually impossible to figure out whether any individual grant had been backdated.

Since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation. Backdated stock options would be considered discounted stock options triggering additional taxes and penalties at vesting or exercise. Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating. The practice of backdating itself is not illegal, as it is granting of discounted stock options. What is illegal is the improper disclosures, both in SEC filings and financial records.

Academic researchers had long been aware of the pattern, exhibited by some companies, of share prices rising dramatically in the days following grants of stock options to senior management. However, in late 2005 and early 2006, the issue of stock options backdating gained a wider audience. Numerous financial analysts replicated and expanded upon the prior academic research, developing lists of companies whose stock price performance immediately after options grants to senior management (the purported dates of which can be ascertained by inspecting a company's Form 4 filings, generally available online at the SEC's website) was suspicious.

Misleading Shareholders

Backdating stock options is not necessarily illegal. Backdating becomes illegal when a company's shareholders are misled as a result of the practice. For instance, public companies generally grant stock options in accordance with a formal stock option plan approved by shareholders at an annual meeting. Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant. If a company grants options on June 1 (when the stock price is $100), but backdates the options to May 15 (when the price was $80) in order to make the option grants more favorable to the grantees, the fact remains that the grants were actually made on June 1, and if the exercise price of the granted options is $80, not $100, it is below fair market value. Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan.

The other major way that backdating can be misleading to investors relates to the method by which the company accounts for the options. Until very recently, a company that granted stock options to executives at fair market value did not have to recognize the cost of the options is a compensation expense. However, if the company granted options with an exercise price below fair market value, there would be a compensation expense that had to be recognized under applicable accounting rules. If a company backdated its stock options, but failed to recognize a compensation expense, then the company's accounting may not be correct, and its quarterly and annual financial reports to investors may be misleading.

Deferral of Income Recognition

According to Section 83 of the Code, employees who receive property from the employer must recognize taxable income in the year in which that property vests (is free from restrictions and other risks of forfeiture). Stock options granted which exercise price below the then current fair market value has intrinsic value equal to the difference between the market price and the strike price. Such backdating may be construed as illegally avoiding income recognition because falsely under-reporting the market price of such stocks makes them appear to have no value in excess of the strike price at the time the option is granted.